Gold Juniors’ Q2’18 Fundamentals

The junior gold miners’ stocks have been thrashed in August, plummeting to brutal multi-year lows. Such carnage naturally left sentiment far more bearish than usual in this forsaken contrarian sector. But these extremely-battered gold-stock prices certainly aren’t justified fundamentally. Junior gold miners’ collective results from their just-completed Q2’18 earnings season prove their stock prices need to mean revert way higher.

Four times a year publicly-traded companies release treasure troves of valuable information in the form of quarterly reports. Companies trading in the States are required to file 10-Qs with the US Securities and Exchange Commission by 45 calendar days after quarter-ends. Canadian companies have similar requirements. In other countries with half-year reporting, many companies still partially report quarterly.

The definitive list of elite “junior” gold stocks to analyze comes from the world’s most-popular junior-gold-stock investment vehicle. This week the GDXJ VanEck Vectors Junior Gold Miners ETF reported $4.5b in net assets. Among all gold-stock ETFs, that was second only to GDX’s $8.4b. That is GDXJ’s big-brother ETF that includes larger major gold miners. GDXJ’s popularity testifies to the great allure of juniors.

Unfortunately this fame created serious problems for GDXJ a couple years ago, resulting in a stealthy major mission change. This ETF is quite literally the victim of its own success. GDXJ grew so large in the first half of 2016 as gold stocks soared in a massive upleg that it risked running afoul of Canadian securities laws. And most of the world’s smaller gold miners and explorers trade on Canadian stock exchanges.

Since Canada is the center of the junior-gold universe, any ETF seeking to own this sector will have to be heavily invested there. But once any investor including an ETF buys up a 20%+ stake in any Canadian stock, it is legally deemed to be a takeover offer that must be extended to all shareholders! As capital flooded into GDXJ in 2016 to gain junior-gold exposure, its ownership in smaller components soared near 20%.

Obviously hundreds of thousands of investors buying shares in an ETF have no intention of taking over gold-mining companies, no matter how big their collective stakes. That’s a totally-different scenario than a single corporate investor buying 20%+. GDXJ’s managers should’ve lobbied Canadian regulators and lawmakers to exempt ETFs from that 20% takeover rule. But instead they chose an inferior, easier fix.

Since GDXJ’s issuer controls the junior-gold-stock index underlying its ETF, it simply chose to unilaterally redefine what junior gold miners are. It rejiggered its index to fill GDXJ’s ranks with larger mid-tier gold miners, while greatly demoting true smaller junior gold miners in terms of their ETF weightings. This controversial move defying long decades of convention was done quietly behind the scenes to avoid backlash.

There’s no formal definition of a junior gold miner, which gives cover to GDXJ’s managers pushing the limits. Major gold miners are generally those that produce over 1m ounces of gold annually. For decades juniors were considered to be sub-200k-ounce producers. So 300k ounces per year is a very-generous threshold. Anything between 300k to 1m ounces annually is in the mid-tier realm, where GDXJ now traffics.

That high 300k-ounce-per-year junior cutoff translates into 75k ounces per quarter. Following the end of the gold miners’ Q2’18 earnings season in mid-August, I dug into the top 34 GDXJ components’ results. That’s simply an arbitrary number that fits neatly into the tables below. Although GDXJ included a staggering 71 component stocks this week, the top 34 accounted for a commanding 81.1% of its total weighting.

Out of these top 34 GDXJ companies, only 4 primary gold miners met that sub-75k-ounce-per-quarter qualification to be a junior gold miner! Their quarterly production is rendered in blue below, and they collectively accounted for just 8.9% of GDXJ’s total weighting. But even that is really overstated, as 3 of these are long-time traditional major silver miners that are increasingly diversifying into gold in recent years.

GDXJ is inarguably now a pure mid-tier gold-miner ETF, and really ought to be advertised as such. While its holdings include some of the world’s best gold miners with huge upside potential, the great majority definitely aren’t classic junior gold miners. At least this ETF’s big composition changes are stabilizing, as Q2’18 was the first quarter since mid-2016 where GDXJ’s components didn’t radically change year-over-year.

I’ve been doing these deep quarterly dives into GDXJ’s top components for years now. In Q2’18, fully 32 of the top 34 GDXJ components were also GDX components! These are separate and distinct ETFs, a “Gold Miners ETF” and a “Junior Gold Miners ETF”. So they shouldn’t have to own many of the same companies. In the tables below I highlighted the symbols of rare GDXJ components not also in GDX in yellow.

These 32 GDX components accounted for 78.4% of GDXJ’s total weighting, not just its top 34. They also represented 38.0% of GDX’s total weighting. Thus nearly 4/5ths of this “Junior Gold Miners ETF” is made up by over 3/8ths of the major “Gold Miners ETF”! These GDXJ components also in GDX start at the 10th-highest weighting in that latter larger ETF and extend down to 47th. GDXJ is mostly smaller GDX stocks.

In a welcome change from GDXJ’s vast component turmoil of recent years, only 2 of its top 34 stocks are new since Q2’17. Their symbols are highlighted in light blue below. Thus the top GDXJ components’ collective results are finally getting comparable again in year-over-year terms. Analyzing ETFs is much easier if their larger components aren’t constantly in flux. Hopefully changes going forward are relatively minor.

Despite all this, GDXJ remains the leading “junior-gold” benchmark. So every quarter I wade through tons of data from its top components’ latest results, and dump it into a big spreadsheet for analysis. The highlights make it into these tables. Most of these top 34 GDXJ gold miners trade in the US and Canada, where comprehensive quarterly reporting is required by regulators. But others trade in Australia and the UK.

In these countries and most of the rest of the world, regulators only mandate that companies report their results in half-year increments. Some do still issue quarterly production reports, but don’t release financial statements. There are wide variations in reporting styles, data presented, and release timing. So blank fields in these tables mean a company hadn’t reported that particular data for Q2’18 as of this Wednesday.

The first couple columns of these tables show each GDXJ component’s symbol and weighting within this ETF as of this week. While most of these stocks trade on US exchanges, some symbols are listings from companies’ primary foreign stock exchanges. That’s followed by each gold miner’s Q2’18 production in ounces, which is mostly in pure-gold terms. That excludes byproduct metals often present in gold ore.

Those are usually silver and base metals like copper, which are valuable. They are sold to offset some of the considerable costs of gold mining, lowering per-ounce costs and thus raising overall profitability. In cases where companies didn’t separate out gold and lumped all production into gold-equivalent ounces, those GEOs are included instead. Then production’s absolute year-over-year change from Q2’17 is shown.

Next comes gold miners’ most-important fundamental data for investors, cash costs and all-in sustaining costs per ounce mined. The latter directly drives profitability which ultimately determines stock prices. These key costs are also followed by YoY changes. Last but not least the annual changes are shown in operating cash flows generated, hard GAAP earnings, sales, and cash on hand with a couple exceptions.

Percentage changes aren’t relevant or meaningful if data shifted from positive to negative or vice versa, or if derived from two negative numbers. So in those cases I included raw underlying data rather than weird or misleading percentage changes. This whole dataset together offers a fantastic high-level read on how the mid-tier gold miners are faring fundamentally as an industry. August’s plunge wasn’t righteous.

It was great to see GDXJ’s top 34 components almost unchanged from Q2’17, with only two new stocks in those ranks. My previous essays on GDXJ components’ quarterly results had been a sea of light blue since 2016. But one of the new components in Q2’18 is inexplicably the giant largely-African miner AngloGold Ashanti. It produced an enormous 805k ounces of gold last quarter, the largest in GDXJ by far.

Remember that major-gold-miner threshold has long been 1m+ ounces per year. AU’s production is annualizing to over 3x that, making this company the world’s 3rd-largest gold miner last quarter. Why on earth would managers running a “Junior Gold Miners ETF” even consider AngloGold Ashanti? It is as far from junior-dom as gold miners get. Having so many of the same stocks in both GDXJ and GDX is a big problem.

Such massive overlap between these two ETFs is a huge lost opportunity for VanEck. It owns and manages GDX, GDXJ, and even the MVIS indexing company that decides exactly which gold stocks are included in each. With one company in total control, there’s no need for any overlap in the underlying companies of what should be two very-different gold-stock ETFs. Inclusion ought to be mutually-exclusive.

VanEck could greatly increase the utility of its gold-stock ETFs and thus their ultimate success by starting with one big combined list of the world’s better gold miners. Then it could take the top 20 or 25 in terms of annual gold production and assign them to GDX. Based on Q2’18 production, that would run down near 127k or 92k ounces per quarter. Then the next-largest 30 or 40 gold miners could be assigned to GDXJ.

Getting smaller gold miners back into GDXJ would be a huge boon for the junior-gold-mining industry. Most investors naturally assume this “Junior Gold Miners ETF” owns junior gold miners, which is where they are trying to allocate their capital. But since most of GDXJ’s funds are instead diverted into much-larger mid-tiers and even some majors, the juniors are effectively being starved of capital intended for them.

That’s one of the big reasons smaller gold miners’ stock prices are so darned low. They aren’t getting enough capital inflows from gold-stock-ETF investing. So their share prices aren’t bid higher. They rely on issuing shares to finance their exploration projects and mine builds. But when their stock prices are down in the dumps, that is heavily dilutive. So GDXJ is strangling the very industry its investors want to own!

Back to these mid-tier gold miners’ Q2’18 results, production is the best place to start since that is the lifeblood of the entire gold-mining industry. These top 34 GDXJ gold miners that had specifically reported Q2 production as of the middle of this week produced 4467k ounces. That surged a massive 24.7% YoY, implying these miners are thriving. But that’s almost all driven by that huge 805k-ounce boost from AU’s inclusion.

Without AngloGold Ashanti which wasn’t there in Q2’17, the rest of the top 34 GDXJ gold miners saw their total production climb 2.2% YoY to 3662k ounces. That’s a little behind the 3.0% annual growth in overall global mine production in Q2’18 according to the World Gold Council’s latest Gold Demand Trends report. But these mid-tier miners are still faring far better than the majors that dominate that other GDX ETF.

As discussed last week in my essay on the GDX gold miners’ Q2’18 results, their production adjusted for quarterly data availability plunged a sharp 7.7% YoY! With big economically-viable gold deposits getting increasingly hard to discover, the majors are really struggling to replace depleting production. So much of the growth is coming from the mid-tiers and juniors, which will help their stock prices outperform the majors.

Starting from far-lower production bases, most of the smaller gold miners can ramp production by adding single new mines. These are often modest in scale and cost compared to the giant mines the majors need to target. Since growing production greatly boosts profits, investment capital will increasingly flow into mid-tier gold miners in coming years. So GDXJ’s upside should well outpace the major-dominated GDX’s.

For all GDXJ’s faults, it does still offer investors exposure to much-smaller gold miners. The average quarterly production of all the top 34 GDXJ miners reporting it in Q2 was 144.1k ounces. That is 44% smaller than the 258.3k averaged by the top 34 GDX miners last quarter. And again AU’s crazy inclusion really skews this. Ex-AU, the GDXJ average falls to 122.1k. That annualizes to 488k, solidly in the mid-tier realm.

With today’s set of top-34 GDXJ gold miners achieving relatively-good production growth, their costs per ounce should’ve declined proportionally. Higher production yields more gold to spread mining’s big fixed costs across. And lower per-ounce costs naturally lead to higher profits. So production growth is highly sought after by gold-stock investors, with companies able to achieve it commanding premium prices.

There are two major ways to measure gold-mining costs, classic cash costs per ounce and the superior all-in sustaining costs per ounce. Both are useful metrics. Cash costs are the acid test of gold-miner survivability in lower-gold-price environments, revealing the worst-case gold levels necessary to keep the mines running. All-in sustaining costs show where gold needs to trade to maintain current mining tempos indefinitely.

Cash costs naturally encompass all cash expenses necessary to produce each ounce of gold, including all direct production costs, mine-level administration, smelting, refining, transport, regulatory, royalty, and tax expenses. In Q2’18, these top 34 GDXJ-component gold miners that reported cash costs averaged $631 per ounce. That was actually up a slight 0.5% YoY, contrary to what you’d expect with higher production.

The majority of reporting gold miners saw cash costs rise significantly last quarter. There were plenty of challenges at various individual mines, including unexpected downtimes and lower ore grades. Both of those yield fewer ounces to bear the burden of gold mining’s big fixed costs. General price inflation is also mounting thanks to the trillions of dollars of money central banks conjured out of thin air over the past decade.

$631 per ounce is still very healthy, not much worse than the GDX majors’ average of $610 last quarter. That means these elite mid-tier gold miners could temporarily weather gold prices way down into the mid-$600s and still keep their mines running! At worst in mid-August, gold plunged to $1174 on close driven by epic all-time-record gold-futures short selling. Gold had fallen 4.1% month-to-date by that point, a big loss.

But the GDXJ gold miners suffered disproportionally, with this ETF’s price plummeting 15.5% MTD in sympathy with gold! That 3.8x downside leverage was excessive, the result of irrational herd sentiment. GDXJ’s share price was crushed to a brutal 2.4-year low, implying these miners are in fundamental peril. But with gold still trading a whopping 86% above their cash costs even at recent lows, that clearly wasn’t the case.

Way more important than cash costs are the far-superior all-in sustaining costs. They were introduced by the World Gold Council in June 2013 to give investors a much-better understanding of what it really costs to maintain gold mines as ongoing concerns. AISCs include all direct cash costs, but then add on everything else that is necessary to maintain and replenish operations at current gold-production levels.

These additional expenses include exploration for new gold to mine to replace depleting deposits, mine-development and construction expenses, remediation, and mine reclamation. They also include the corporate-level administration expenses necessary to oversee gold mines. All-in sustaining costs are the most-important gold-mining cost metric by far for investors, revealing gold miners’ true operating profitability.

These top 34 GDXJ gold miners reporting AISCs saw them average $886 per ounce in Q2’18. That was also up a modest 0.9% YoY, so costs didn’t decline proportionally with rising production. Still $886 is an excellent level compared to prevailing gold prices, and competitive with the GDX majors which averaged $856 last quarter. $886 is right in line with the past four quarters’ trend of $879, $877, $855, and $923 too.

The fundamental implications of this are very bullish, proving that this month’s gold-stock capitulation was purely an overdone herd-sentiment thing. Gold averaged $1306 in Q2’18, up 3.9% YoY. That means the top GDXJ gold miners were earning average profits just under $420 per ounce. Thanks to AISCs mostly holding the line and modestly-higher gold prices, those earnings rose a solid 10.7% YoY from $379 in Q2’17.

With gold mining considerably more profitable last quarter than a year earlier, you’d think the gold-stock prices would’ve been proportionally higher. Yet GDXJ’s average price in Q2 still slipped 1.1% lower YoY, which makes no sense fundamentally. And even if August’s capitulation-grade $1175 gold was able to magically persist as if those crazy-record gold-futures shorts were never covered, gold mining is still very profitable.

At Q2’18’s average AISCs which are again right in line with recent years’ levels, $1175 gold would still yield hefty $289-per-ounce profits for the mid-tier gold miners. Those don’t justify deep multi-year lows in gold-stock prices. And these profits will balloon dramatically as gold inevitably mean reverts much higher. Extreme gold-futures short-covering buying is imminent, and will be proportional to August’s record shorting.

The impact of higher gold prices on mid-tier-gold-miner profitability is easy to model. Assuming flat all-in sustaining costs at Q2’s $886 per ounce, 10%, 20%, and 30% gold rallies from mid-August’s lows would lead to collective gold-mining profits surging 40%, 81%, and 122%! And another 30% gold upleg isn’t a stretch at all. In the first half of 2016 alone after the first stock-market corrections in years, gold soared 29.9%.

GDXJ skyrocketed 202.5% higher in 7.0 months in largely that same span! Gold-mining profits and thus gold-stock prices surge dramatically when gold is powering higher. Years of neglect from investors have forced the gold miners to get lean and efficient, which will really amplify their fundamental upside during the next major gold upleg. The investors and speculators who buy in early and cheap could earn fortunes.

As long as the gold miners can produce gold at all-in sustaining costs way below prevailing gold prices, they will generate big profits for investors. Eventually their stock-price levels have to reflect their true underlying profitability. With $1175+ gold and $886 AISCs, the mid-tier gold miners’ stocks must mean revert way higher. Their extreme low levels today are fundamentally absurd, they can’t and won’t last for long.

With GDXJ’s radical composition changes finally settling down, the rest of its top 34 components’ core fundamentals are finally comparable year-over-year again. It’s nice to have that massive rejiggering in GDXJ’s underlying index past us. These elite mid-tier miners’ total revenues climbed 9.3% YoY to $5558m, well outpacing gold’s 3.9% YoY gain. That 2.2% higher production excluding AngloGold Ashanti also helped.

Those sales helped generate cash flows from operations of $1384m. While 5.1% lower YoY, that is still massively positive for this small contrarian sector. As long as gold mines are yielding far more cash than they cost to run, the mid-tier gold miners remain fundamentally healthy. Positive cash flows build capital necessary to expand operations, and helped drive these miners’ cash war chests up 9.3% YoY to $6784m in Q2.

But their hard GAAP profits as reported to regulators collectively looked terrible, collapsing from a strong $751m in Q2’17 to a big $146m loss in Q2’18! Is that the fundamental monkey wrench justifying these wretched stock-price levels? Not at all, as big unusual items flushed through bottom lines can make profits comparisons very misleading. There were two huge non-recurring items that mostly drove this big swing.

A year ago in Q2’17, elite mid-tier miner IAMGOLD reported a colossal $524m one-time non-cash gain from the reversal of mine-impairment charges. That accounted for nearly 70% of the top 34 GDXJ gold miners’ overall profits that quarter! Without that unusual item, their total Q2’17 profits were just $227m. Another unusual item heavily skewed last quarter’s latest profits, coming from mid-tier gold miner New Gold.

Gold mining is very challenging and risky, with many problems not evident until mining is well underway. New Gold’s serious troubles illustrate why diversifying capital across multiple gold miners is essential for all contrarian investors. NGD’s young Rainy River gold mine isn’t living up to potential due to variability in ore grades and processing. So in late July NGD slashed Rainy River’s 2018 production outlook by a huge 30%!

Not only did NGD’s stock crater, but this Rainy River situation is so bad New Gold recorded a $282m impairment charge on that mine! Such unusual non-recurring items flow directly into profits. Without that New Gold disaster, the top 34 GDJX gold miners’ total GAAP earnings in Q2’18 were $136m. While still down a major 40.2% YoY, that $91m drop is a fraction the size of the $897m including those unusual items.

The mid-tier gold miners’ recently-reported solid-to-strong Q2’18 results prove that their brutal plunge in August wasn’t fundamentally righteous. Like all capitulations fueled by cascading stop-loss selling, it was merely a sentimental and technical thing. As gold surges on the record futures short-covering buying that is imminent, the battered gold stocks will mean revert dramatically higher. And the mid-tiers will lead the way.

While GDXJ should certainly no longer be advertised as a “Junior Gold Miners ETF”, it offers exposure to some of the best mid-tier gold miners on the planet. It’s really growing on me, I like this new GDXJ way better than GDX. That being said, GDXJ is still burdened by overdiversification and way too many gold miners that shouldn’t be in there. They are either too large, are saddled with inferior fundamentals, or both.

So the best way to play the gold miners’ coming massive mean-reversion bull is in individual stocks with superior fundamentals. Their gains will ultimately trounce the major ETFs like GDXJ and GDX. There’s no doubt carefully-handpicked portfolios of elite gold and silver miners will generate much-greater wealth creation. GDXJ’s component list is a great starting point, but pruning it way down offers far-bigger upside.

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The bottom line is the mid-tier gold miners reported solid-to-strong fundamentals in their recent Q2’18 results. They were able to modestly grow their production despite the majors’ falling rather sharply. More gold mined combined with essentially-flat costs and higher average gold prices fueled solid profits growth. The mid-tiers’ production costs were far below prevailing gold prices even at mid-August’s deep capitulation lows.

That gold plunge that dragged gold stocks sharply lower was driven by crazy-all-time-record gold-futures short selling. Those extreme positions must soon be closed with proportional buying, which will catapult gold sharply higher. With gold-stock prices trading at such fundamentally-absurd levels today, they ought to soar and really leverage gold’s coming mean-reversion gains. Their post-capitulation upside is huge.

Adam Hamilton, CPA

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